Tuesday, 30 October 2012

Highly recommended: Lionel Martellini's Inefficient Benchmarks in Efficient Markets at the EDHEC Research Institute. Martellini is precise and brief in his explanation of a couple of the slipperiest and most important ideas in finance and investing. Quotes:

" ... cap-weighted indices are inefficient benchmarks, regardless of whether
or not markets are efficient (keeping in mind that they probably are
efficient, at least to a first-order approximation)... " i.e. the implication is that indices like the S&P 500 and the S&P/TSX 60 aren't very good

" ... When the word “efficient” is used in reference to a market, as in the efficient market hypothesis
(EMH) formulated by Eugene Fama in 1970, it suggests that at any given
time, prices in the market fully reflect all available information on
all stocks in the market. ... " and "... there is a consensus regarding the fact that markets can still be regarded as somewhat efficient ... " i.e. it's not impossible but it's hard to outperform the market, considering fees and costs

" ... even if markets are efficient, at least up to a first order
approximation, investors can still be holding highly inefficient
portfolios. The word “efficient”, now applied to a portfolio as opposed
to a market, means that the portfolio performance can be improved
without any increase in risk through an improvement in the portfolio
diversification ..." i.e. it isn't a great idea to invest only in Royal Bank shares even if the price is correct

" ... empirical evidence also suggests that the average investor holds a
severely inefficient portfolio. In other words, the finding here is
that the portfolio held by the average investor, which by definition is a
cap-weighted index, tends to be poorly diversified. This result is
hardly a new finding, ..." i.e. buying SPY (S&P 500 tracker ETF) or even VTI (Vanguard Total US Market ETF) or XIC (S&P/TSX Total Market ETF) is NOT the ideal thing to do.

"... various alternative weighting schemes have been proposed to improve upon cap-weighting (see Amenc et al.
(2011), Arnott, Hsu and Moore (2005), Choueifaty and Coignard (2008),
Maillard, Roncalli and Teiletche (2008) to name but a few), and it is
now commonly accepted that moving away from cap-weighting tends to
enhance diversification and increase risk-adjusted performance over long
horizons. ..." i.e. consider dumping SPY and XIC. I think the best practical answer is an empirical matter - if another non-cap-weighted (like equal-weighted, or fundamental weighted) index ETF exists for the asset class with reasonable costs that do not eat up the performance gain (e.g. perhaps PRF, EWI, RSP, PXC, CRQ;

RBC302's annualized 5-year return of -0.12% (per Morningstar), including the all-important adjustment for fees, beats XEN's -1.12% (per the Globe Watchlist) by a whopping 1% per year!! and the benchmark cap-weight market fund iShares XIU's -0.83% (also from Globe WatchList) by 0.71%! Of course, the data might not be strictly comparable coming as it does from different sources - why the heck can't the data providers give us ETFs and mutual funds together since most investors want to compare the two?! That's right, an actively managed high-MER mutual fund has beaten the index by a good margin, even after fees.

What explains the difference?
1) RBC has been good at excluding a number of stocks that have been losers. RBC's final investment decision-making step, after the initial screening for the Jantzi social criteria, is to pick stocks with "... above-average financial fundamentals while considering broader factors,
such as economic trends, interest rates and the outlook for profits,
valuations and stock prices". We only have the top 25 stocks to look at, since RBC doesn't reveal the whole portfolio, but the holdings differences between RBC302 and XEN are significant. 8 stocks are different. The spreadsheet shows in red, which stocks do not appear in the top 25 of the other. Of the 8 in XEN, but not in RBC302, six have significantly negative annualized 5-year total returns.
2) RBC seems to be fairly good at picking winners. As for the stocks in RBC302 that have replaced those losers, 5 out of 8 are 5-year positive and the positives are stronger than the negative. It's interesting that RBC302 is much less concentrated than XEN. It's top 25 only add up to 56.8% of assets vs 82.2% for XEN. RBC is no closet indexer with this fund!

Is "socially responsible" inclusion partly in the eye of the beholder?
Not a single one of the red stocks in the top 25 holdings of RBC302 appears anywhere in XEN, not in the top 25 of XEN, nor within the 61 total holdings of the XEN. Yet all of these stocks are large enough to appear in cap-weight benchmark XIU. What is going on? XEN is strictly a Jantzi index tracker so those stocks must have been screened out as unacceptable according to socially responsible criteria. How the heck does RBC get to put them back in? Unfortunately, the Jantzi index composition and its exact methodology are not disclosed so we cannot go back to the true source to figure this out. It would be ironic if RBC has been beating the virtuous socially responsible index by cheating!

Wednesday, 24 October 2012

It sure is confusing to do the right thing. My most recent foray into looking at what is often called Socially Responsible Investing (SRI), or investing based on Environmental Social and Governance (ESG) factors, started with a recent news item in the Financial Post.

Group of 49 ethical funds call for greener oilsands made the interesting statement that "... the current approach to development, particularly the management of the
environmental and social impacts, threatens the long-term viability of
the oilsands as an investment". That's interesting, I said to myself, at last an analysis that takes the viewpoint of the investor who wants to do right but also to understand the long term investment issues. Alas, the future investment risk analysis consists only of a couple of sentences about aboriginal lawsuits and market access restrictions due to potential low-carbon fuel standards laws in the USA. When I tracked down the original stuff from Ceres (why don't mainstream news sites provide a link directly to original sources anyways?), the entire content of the press release and document issued by lobby group Ceres is occupied with micro-management - telling the industry what it should do and what its goals should be. Such blatant lobbying with only the slightest veneer of investment content does more to discredit their effort than gain investor support.

The trickster feel to the Ceres release was exacerbated by the reference to investors with "$2 trillion under management" and "investments in Alberta's oilsands", which disingenuously fails to say exactly what stake those 49 funds have. Presumably if the oil sands producers are doing a bad ESG job, the ethical funds won't be invested, will they?

And if the companies are doing a good job, why do they need Ceres to tell them how to operate at such a micro level? Isn't it curious that the Jantzi Social Index Fund from iShares (TSX symbol: XEN) which buys into "... companies that reflect a higher standard of environmental and social performance", includes among its holdings several notable oil sands companies like Suncor, Imperial Oil and Nexen. Another holier-than-legally-required list, the Newsweek 2012 Green Companies Global Rankings, has Suncor in its list too, as well as another oil sands major Shell (see Wikipedia's oil sands article for others).

The disappointment over the oil sands article turned to real cognitive dissonance distress (hey, I paid for my university education so I get to use those lovely buzzwords) when I looked more closely at the Newsweek list. How the heck do all those major world banks get on the list - RBS, Lloyds, Barclays, Citigroup, Morgan Stanley, Goldman Sachs - those fine upstanding institutions whose follies almost tore apart the world's financial system in 2008 and whose miserable economic consequences continue to this day? Is it ok if banks destroy the economy as long as they recycle, have a small carbon footprint, hire lots of women and minorities and get involved in their local communities?

It's not that it is necessarily misguided to expect more than obeying the law as the desirable mode of operation from companies. Indeed, a few years ago in the Financial Times, Rob Arnott wrote an eloquent piece called Why poor moral ethics prove costly on the necessity for moral ethics (doing what is right) instead of just legal ethics (doing what is allowed).

My objective as an investor is to consider companies holistically. No company is perfect in every way and some things matter more than others. The range of ESG issues shown in the chart image below from index provider MSCI must be considered as a whole. ESG is not enough either. I cannot afford to invest in dud companies that lose money and go out of business no matter what their ESG score may be. A financial and business rating needs to be integrated with the ESG.

What I'd want is some combination of the ESG ratings that determine the holdings of ETFs like XEN in Canada or KLD, DSI, NASI and EAPS in the USA (see these ETFs' details on the ETFdb screen for SRI funds) plus an active index methodology like the RAFI Fundamental ETFs CRQ or PXC in Canada or PRF, PXF, PDN and the like in the USA. They could be called "Fundamental Virtue" ETFs.

Tuesday, 2 October 2012

Want to avoid an Earl Jones nightmare in your life? Do you know whether the person who wants to sell you mutual funds is on the up-and-up? Ken Kivenko of CanadianFundWatch.com gives us the details on how exactly to check out mutual fund salespeople (technically, dealing representatives, self-termed as advisors) in Checking Registration and Disciplinary History. Unfortunately, the dogs-breakfast regulatory system in Canada means that it takes three pages of single-spaced explanation on how to do this and even then it is not foolproof, but hopefully readers will believe it is worth the effort.

There is another solution of course - be a DIY investor. Then you can wrestle with the question of whether you should entrust yourself to invest your own money.